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Security Analysis and Portfolio Management

About the Book

The book finely begins with a brief
introduction to risk and its types. It also explains the extent to which each category should be given importance. Then the transition happens in the next chapter where it explains different types of analysis in terms of factors like; Economic Analysis (macro level), Industry Analysis (micro level) and then Company Analysis. All this is done with great depth and relevance.

Key Features First book in india on SAPM with coverage of topics like VaR, Behavioral Finance and Commodity Markets. Book covers in depth topics like Risk return, Modern Portfolio Theory, Efficient Market, etc.

Security Analysis and Portfolio Management

1 CHAPTER

Security Analysis and Portfolio Management

INTRODUCTION
Risk management is the process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making. Essentially, risk management occurs anytime an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given their investment objectives and risk tolerance.

Security Analysis and Portfolio Management

RISK IN A TRADITIONAL SENSE

Risk in holding securities is generally associated with possibility that realized returns will be less than the returns that were expected. The source of such disappointment is the failure of dividends (interest) and/or the security's price to materialize as expected. Forces that contribute to variations in return price or dividend interest) constitute elements of risk. Some influences are external to the firm, cannot be controlled, and affect large numbers of securities. Other influences are internal to the firm and are controllable to a large degree. In investments, those forces that are uncontrollable, external and board in their effect are called sources of systematic risk.

Security Analysis and Portfolio Management

SYSTEMATIC RISK
Systematic risk refers to that portion of total variability in return caused by factors affecting the prices of all securities. Economic, political, and sociological changes are sources of systematic risk. Their effect is to cause prices of nearly all individual common stocks and/or all individual bonds to move together in the same manner. For example, if the economy is moving toward a recession and corporate profits shift downward, stock prices may decline across a broad front. Nearly all stocks listed on the National Stock Exchange (NSE) move in the same direction as the NSE Index. On an average, 50 percent of the variation in a stock's price can be explained by variation in the market index. In other words, about one-half the total risk in an average common stock is systematic risk.

Security Analysis and Portfolio Management

Market Risk
Finding stock prices falling from time to time while a company's earnings are rising, and vice versa, is not uncommon. The price of a stock may fluctuate widely within a short span of time even though earnings remain unchanged. Variability in return on most common stocks that is due to basic sweeping changes in investor expectations is referred to as market risk. Market risk is caused by investor reaction to tangible as well as intangible events. Expectations of lower corporate profits in general may cause the larger body of common to fall in price. Investors are expressing their judgment that too much is being paid for earnings in the light of anticipated events. The basis for the reaction is a set of real, tangible events political, social, or economic. Intangible events are related to market psychology. Market risk is usually touched off by a reaction to real events, but the emotional instability of investors acting collectively leads to a snowballing over reaction.
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Security Analysis and Portfolio Management

Interest-rate Risk
Interest-rate risk refers to the uncertainty of future market values and of the size of future income, caused by fluctuations in the general level of interest rates. The root cause of interest-rate risk lies in the fact that, as the rate of interest paid on Indian Government Securities (IGSs) rises or falls, the rates of return demanded on alternative investment vehicles such as stocks and bonds issued in the private sector, rise or fall. In other words, as the cost of money changes for nearly risk-free securities (IGSs), the cost of money to more risk-prone issuers (Private sector) will also change. Investors normally regard IGSs as coming closest to being risk free. The interest rates demanded on IGSs are thought to approximate the "pure" rate of interest, or the cost of hiring money at no risk. Changes in rates of interest demanded on IGSs will permeate the system of available securities, from corporate bonds down to the riskiest common stocks. Interest rates on IGSs shift with changes in the supply and demand for government securities.
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Security Analysis and Portfolio Management

Purchasing Power Risk

Market risk and interest-rate risk can be defined in terms of uncertainties as to the amount of current dollars to be received by an investor. Purchasingpower risk is the uncertainty the purchasing power of the amounts to be received. In more everyday terms, purchasing power risk refers to the impact of inflation or deflation on an investment. If we think of investment as the postponement of consumption, we can see that when a person purchases a stock, he has foregone the opportunity to buy some good or service for as long as he owns the stock.

Security Analysis and Portfolio Management

UNSYSTEMATIC RISK
Unsystematic risk is the portion of total risk that is unique or peculiar to a firm or an industry, above and beyond that affecting securities markets in general. Factors such as management capability, consumer preferences, and labor strikes can cause unsystematic variability of returns for a company's stock. Because these factors affect one industry and/or one firm, they must be examined separately for each company. The uncertainty surrounding the ability of the issuer to make payments on securities stems from two sources: (1) The operating environment of the business, and (2) The financing of the firm.

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Security Analysis and Portfolio Management

Business Risk
Business risk is a function of the operating conditions faced by a firm and the variability these conditions inject into operating income and expected to increase 10 percent per year over the foreseeable future, business risk would be higher if operating earnings could grow as much as 14 percent or as little as 6 percent than if the range were from a high of 11 percent to a low of 9 percent. The degree of variation from the expected trend would measure business risk. Business risk can be divided into two broad categories: external and internal. Internal business risk is largely associated with the efficiency with which a firm conducts its operations within the broader operating environment imposed upon it. Each firm has its own set of internal risks, and the degree to which it is successful in coping with them is reflected in operating efficiently. To large extent, external business risk is the result of operating conditions imposed upon the firm by circumstances beyond its control.
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Security Analysis and Portfolio Management

Financial Risk
Financial risk is associated with the way in which a company finances its activities. We usually gauge financial risk by looking at the capital structure of a firm. The presence of borrowed money of debt in the capital structure creates fixed payment in the form of interest that must be sustained by the firm. The presence of these interest commitments fixed interest payments due to debt of fixeddividend payments on preferred stock causes the amount of residual earnings available for common stock dividends to be more variable than if no interest payments were required. Financial risk is avoidable risk to the extent that managements have the freedom to decide to borrow or not to borrow funds.

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Security Analysis and Portfolio Management

Assigning Risk Allowances (Premiums)

One way of quantifying risk and building a required rate of return (r), would be to express the required rate as comprising a riskless rate plus compensation for individual risk factors previously enunciated, or as: r=i+p+b+f+m+o Where: i = real interest rate (risk less rate) p = purchasingpower-risk allowance b = businessrisk allowance f = financialrisk allowance m = marketrisk allowance o = allowance for "other" risks
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Security Analysis and Portfolio Management

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Security Analysis and Portfolio Management